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Monday, August 27, 2007

Combating the costs of fund management

At a wholesale level, fund management can be very cheap, with customers being charged as little as one basis point out of assets under management a year. At a fee of one basis point, a fund manager who runs Rs.100,000 of your money earns Rs.10 a year out of it. This is the price achieved by bulk fund management abroad and in India.

These low prices are just not visible to the end customer in India. EPFO is expensive. Most mutual funds are very expensive. The fund management products sold by insurance companies are outrageously expensive. The key problem with mutual funds and insurance companies appears to be the distributor-centric business model. Achieving lower fees requires (a) Modifying the implementation of that model or (b) Starting over with a new business model.

SEBI has recently floated a new proposal to remove loads on direct applicants for mutual funds, who would then have a choice to achieve a lower cost channel by doing it on their own, when compared with the high costs associated with a distributor. See reports by Rachna Monga in Mint and George Mathew and Sandeep Singh in Indian Express. For particularly informed commentary on this proposal, see Ajit Dayal in Indian Express, and Gautam Chikermane, also in Indian Express.

I am sympathetic to this line of thought. What SEBI is proposing is a step forward. However, I worry that it represents a small move which does not challenge the fundamental agent-driven business model. What the agents could lose in this might easily be made up in other ways.

These recent events have brought a fresh focus upon ways to achieve low cost fund management. Four elements come to mind:

Avoid fund management products sold by insurance companies

The worst excesses in terms of fees and expenses seem to be emanating from insurance companies. On this subject, see this piece by Deepti Bhaskaran in Express Money. When your friendly neighbourhood accountant comes to you, suggesting that you sign up for an insurance product so as to save taxes, it would help to think thrice about it.

Quantum Mutual Fund

Ajit Dayal's outfit is a rare mutual fund which is trying to break with the distributors. If active management is your thing, then this is a good way to go. But unlike (say) Vanguard, quantum is not single-mindedly fighting to bring down fees and expenses - a thought process that inevitably takes you to index funds.

Index funds and ETFs

The cheapest fund management products in India today are the index funds, particularly the ETFs. Benchmark's Nifty fund charges an AUM fee of 45 basis points. As an aside, Benchmark staff informally says that if there is a 10x increase in the AUM, this price can come down to 20 bps and if there is a 100x increase in the AUM, the price can come down to 7 bps.
A key insight of the ETF path is that the customer gets his work done through the extremely competitive, transparent and efficient stock broking industry. A customer who goes to his stock broker seeking to buy an ETF gets a low price with no hidden catches - unlike the customer who deals with an agent and tries to buy a conventional mutual fund product or insurance product.

The New Pension System (NPS)

The best eye-popping numbers for saving money in fund management come from the New Pension System. These are early days and it is not yet clear how small these numbers will be. Stay tuned, for the NPS reflects a full-blown thought process of fully redesigning a fund management mechanism so as to achieve a good deal for the customer.

A simple idea that is well appreciated worldwide is the importance of fighting fees and expenses in fund management. Good returns in fund management are a possibility, but the fees and expenses paid are a certainty. The international evidence suggests that paying more for fund management generates reduced returns. A remarkable twist to this tale in India lies in the “distributors”, or agents, who sell fund management products. Fund managers have resorted to making very large payments to these agents, to the point where the profits of the agent sometimes exceed the profits of the financial firm. The chief executives of financial firms privately gripe about this state of affairs, but have not been willing to break with the existing system. As a consequence, customers of mutual funds, and particularly those of insurance companies, are getting a poor deal. All too often, customers of insurance companies are blindly placing money in schemes with the intention of saving taxes, and ending up fuelling the profits of the agent who is selling them the scheme. The non-transparency and high charges that are in place with most mutual funds, and particularly with insurance companies, fuel the discomfort of critics of modern finance, who see “professional fund management” as a way to channel the money of ordinary citizens to financial fat cats.

Exchange traded funds (ETFs) are a promising way out, because the customer is able to go to a stock broker to get invested, and stock broking is a transparent, competitive and efficient industry with very low charges. The lowest-cost fund management accessible to an individual in India is the ETF. Only one active management vehicle — Quantum Mutual Fund — has broken with the agent system, and has so far experienced limited success.

The Securities and Exchange Board of India (Sebi) has now proposed that customers be given a zero-cost alternative whereby they are able to use the Internet and get their money to the mutual fund while bypassing the agent. This is a sound initiative. The insurance regulator, by way of contrast, has offered no positive proposal for addressing the egregious practices of insurance companies. However, the essence of the problem lies not in tweaking the agent system but fundamentally re-shaping the fund management industry.

The New Pension System (NPS) represents an effort at using public policy in order to address the market failures of the fund management industry. In the NPS, the selection of fund managers is done on the basis of an auction where the sum total of fees and expenses is stated up front by the fund manager. This ensures that customers get low prices. Centralisation of record-keeping at the “Central Recordkeeping Agency” (CRA) and an unbundling of customer front-ending to Points of Presence (POPs) help to reduce dramatically the costs of bulk fund management. In a recent auction conducted by the Coal Miners Provident Fund, the winning bid was as low as one basis point of assets per annum.

Many details remain to be worked out — how the CRA will operate, what the charges of the CRA and the PFMs will be, how POPs will be incentivised in a way that avoids the flaws of mutual funds and insurance companies, and how every detail of operation will be structured so as to constantly put pressure in favour of obtaining low fees and expenses. The onus is upon the ministry of finance and the pension regulator to translate the promise of the NPS into reality.

3 comments:

Ajay,I've been following pension reforms and NPS closely. Since you were one of the members very closely associated with pension reforms, I'd like to know your thoughts on chances of India having a regulated private pension TPAs (similar to 401K plan administrators) 4-5 years from now.I'm asking this because I currently work for Vanguard group in US and would like to know if I can leverage pension administration expertise and ASPPA certification in India.I appreciate your response.regards,venkatVenkat.bhamidipati@gmail.com

What appears to be on the cards is (a) Implementation of the NPS and (b) Extension of the NPS to the `unorganised sector' - i.e. the great wide masses. Architecturally, this will look quite different from the US 401(k).

The EPFO remains firmly in control of the mandatory contributions by employees of private firms. As yet, there is no sign of reform at EPFO.

I know it is very old post on Cost of Fund Management. But this article combined with some other articles on ETF and NPS, helped me to invest in EFT and Index funds for the fist time in Jun 2009. It really helped to decide why index funds and then why ETF or Nifty Bees. Thanks for such nice and helpful post.Milind Jadhav

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